“The road to long-term investment success runs through risk control more than through aggressiveness. Over a full career, most investors’ results will be determined more by how many losers they have, and how bad they are, than by the greatness of their winners. Skillful risk control is the mark of the superior investor” — Howard Marks
Investors are always looking for great stocks. You will find blogs, newsletters, and fund managers touting their favorite ideas. While finding great ideas is obviously important, avoiding bad ones is arguably even more important. I think that most investors (including myself) too often forget this fact, abandon their discipline, and allow mediocre (or bad) ideas into their portfolio.
When I recently reviewed my investment performance, I found that while I have had good overall performance, my returns were seriously dragged down by big losers. It is incredibly disappointing to put so much work and effort into finding a great stock, coming up with a clear and accurate thesis, and then making one rash mistake that cancels out all of, or most of, the previous gains. In this way, building an investment track record is kind of like building a reputation. It takes a long time to build, but it can be destroyed by just one terrible mistake. Therefore, while I have tried to learn from all of my investing mistakes, one would be wise to heed Eleanor Roosevelt’s advice: “Learn from the mistakes of others. You can’t possibly make them all yourself.”
With this in mind, I recently read two books that both focus on the importance of eliminating big investing mistakes. I read “The Most Important Thing Illuminated” by Howard Marks. I had already read the regular version of the book, but decided to read the illuminated version that included notes from Joel Greenblatt, Bruce Greenwald, Seth Klarman, and other respected investors. I also read “The Billion Dollar Mistake” by Stephen Weiss. It is also a worthwhile read about the worst investing mistakes of some of the most famous money managers. I highly recommend both books.
My overarching takeaway from these two books can be summarized as: the best way to avoid huge investment mistakes is to have a clear investment philosophy and maintain the discipline to pass on stocks that don’t fall into this investment criteria.
Howard Marks describes it well when he says, “A philosophy has to be the sum of many ideas accumulated over a long period of time from a variety of sources. One cannot develop an effective philosophy without having been exposed to life’s lessons. In my life, I’ve been quite fortunate in terms of both rich experiences and powerful lessons.” My investment philosophy has changed over time as I have learned more about investing and more about myself. Your investment philosophy is not supposed to be a rigid straitjacket, confining you to a single type of investment. However, there is simply so much “noise” in the investing universe — one can easily read 100 different stock ideas per day, and an investment philosophy helps you understand at any given point what you are trying to accomplish and how you are trying to accomplish it.
An investment philosophy loses its value if one succumbs to the temptation to abandon it. This may seem pretty basic, but some of the world’s greatest money managers have lost a lot of money because of this mistake. An example of this from Steve Weiss’ “The Billion Dollar Mistake” was Bill Ackman, one of the greatest investors in the world, and his investment in Borders and Target. Avoiding too much financial leverage was always one of Bill Ackman’s investment tenets, however he abandoned this core principle in his Borders investment where he decided that it was “good enough” and took the risk. In his analysis of this huge mistake, Steve Weiss puts forth, “perhaps it was the zeal to do so that made him bend, perhaps even waive, the selection criteria discipline he had so carefully and assiduously created. Whatever the reason, the deviation from discipline laid the groundwork for that unforced error in the book business and for a very big loss in the big-box megastore sector [Target]…And it had always been part of the Ackman discipline to avoid leverage– whether on the balance sheets of companies he invests in or on his own balance sheet. Ackman’s billion-dollar mistake, therefore, is that he departed from his own investing discipline. The differences in how this detour from discipline played out between Borders and Target are just variations on a theme.”
In my own investing experience, I often see many good write-ups on stocks that I almost immediately pass on because they simply do not fit in my investing style. For example, stocks like Best Buy, Radioshack, and other long-term secular decliners are simply not interesting to me. While they are admittedly potentially good investments, they just are not for me and it is always okay to “pass.” As Warren Buffet says, “In investments, there’s no such thing as a called strike. You can stand there at the plate and the pitcher can throw the ball right down the middle, and if it’s General Motors at $47 and you don’t know enough to decide General Motors at $47, you let it go right on by and no one’s going to call a strike. The only way you can have a strike is to swing and miss.”
Therefore, stocks that are outside my circle of competence such as bio-tech, mining companies, and most energy companies are also immediately discarded. One day, perhaps, I will learn enough about these industries to analyze them, but for now, it makes more sense for me to say “pass” and move on to ideas where I feel like I have the potential to gain an edge.
This past week I spent a lot of time going through about 100 growing micro-caps with strong returns on equity and capital. I was looking to find a few diamonds in the rough, and these principle reminders about discipline proved to be extremely helpful. While a plethora of these 100 stocks were really interesting, many of them were outside of my circle of competence, and I ultimately determined that only six of them were worth a deep dive. Of these six, I found that three are particularly interesting to me as an investor. I have reached out to the management of each of these three firms and will have an update to post by the end of next week (at the latest). I’m really excited about this update because these stocks include:
- A foreign consulting business that has carved out a very profitable niche, is trading for less than 1X EBITDA, is growing over 100% yoy, has a strong net cash position, and has high insider ownership.
- A medical device company with a strong competitive advantage that has led to 30%+ ROC, is growing over 20%/year, and is trading for less than 5X EBITDA
- An innovative company in an old, stable business that is currently under the radar with breakeven operating results. With continued strong top line growth (revenue is up ~20X since 2008), this company could be on the verge of strong profitability that will force a re-rating in the stock (currently trading for .6X revenue)
I think it will be fascinating to find out more about these stocks through further research and from speaking to management. So, make sure to subscribe to the blog and follow me on Twitter to be notified of this update! In the meantime, remember: investors would be wise as Howard Marks notes to focus more on controlling risk and avoiding big losses, because ultimately the upside will take care of itself.
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